My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Sunday, September 13, 2009

One year later: The lessons from the crisis

It is hard to believe that it has been a year since the crisis started - September 15,2008, to be precise. The papers are full of retrospectives, with opinions often overwhelming the facts. I am working on my book on what I learned from the crisis in terms of how I approached valuation and corporate finance. I will post the presentation that I am putting together sometime in the next week.

While most of the articles in the media this week either rehash old stories or focus on human interest (such as looking at where Lehman's employees are today), there are two that I found particularly thought provoking.

His basic thesis is an interesting one. Rather than view Paulson's decision to let Lehman fail, as a catastrophic mistake (the conventional wisdom for many months after the crash), he believes that Lehman's failure and the subsequent panic allowed the government to take actions that it could never have justified before to save AIG. The failure of AIG with its tentacles in every aspect of business would have been far more disastrous than Lehman, according to Nocera.

There is some truth to his argument. The failure of Lehman was not the problem but a symptom of the problem - hopelessly over inflated securities on the books of investment banks and terrible choices on risk. Saving Lehman would not have only have not solved that problem and may in fact have made it worse, by signaling to other banks that they too would be protected. However, I believe that the real mistake was saving Bear Stearns a few months prior. If Bear had been allowed to fail, Lehman may not have had to collapse, but I do understand that I have the benefit of hindsight.

2. The second set of articles that I think are interesting look at how Wall Street has changed (or not changed) as a result of the crisis. The consensus view here seems to be that Wall Street has returned to its old ways, securitizing everything under the sun and paying outlandish bonuses to employees. That does not surprise me. I have discovered that Wall Street is incapable of introspection and has almost no historical memory, for two reasons. The first is a self selection bias: people who choose to be investment bankers and traders prefer to act, rather than analyze, and look forward, not back: that is their strength and their weakness. The second is that success on Wall Street is measured with output - deals made, trading profits generated - rather than input - the quality of the deal making, whether the trading profits came from a sensible, well thought out system.

After every crisis, you hear the cry, "Never again"!! My response is "It is only a matter of time!".

I have looked through your presentation. On slide 29 you give framework for picking the right risk free rate.Hence, I have several comments:1) don't you think that there should be used only 5 government bonds as risk free rate:- US 10 year bond YTM if calculations are in USD- Germany of France 10 year governement bonds YTM if calculations aare made in EUROS- UK 10 year governement bonds YTM if calculations are made in pounds- Japan 10 year government bonds YTM if calculations are in yens- Swiss 10 year governemnt bonds if calculationsare in Swiss francs2) If calculations are made in local currency that its better to use e.g. US 10 year governemnt bonds adjusted to long term inflation expectations of local currency and USD.3) If you take governemtnt bond in local currency which have local currency rating and substract default spread there is probability that rate will be still higher.4) Do you really think that we shall use as risk free government bonds of developing countries? Don't you think that nowadays investor can easily purchase us governement bond which is probably less risky than for example turkish bond - default spread?5) I think ERP is showing all the risk assets have in developing markets.